Know the rules about deducting mortgage interest - especially after a refinance

Friday, January 28, 2011; 11:09 AM

If you buy a really expensive house or a condominium (or even a cooperative apartment), the IRS has some good news for you. Despite the statutory limitation that prohibits you from deducting mortgage interest on any principal amount over $1 million, there is a loophole. You can also deduct interest on up to $100,000 more in home-equity loans.

Mortgage interest and real estate taxes are the only real tax benefits available to American homeowners, although that may change in the coming years. A recent tax commission report has renewed discussion among politicians and economists that these deduction should be limited - if not eliminated entirely.

In the meantime, let's take advantage of these deductions.

Taxpayers have the right to deduct the interest they pay on their mortgage, and there are two categories. First is a complex concept called acquisition debt; the other is home-equity debt.

Acquisition debt is defined in the tax code as debt incurred in acquiring, constructing or substantially improving your principal residence. If you refinance your existing mortgage, the amount of that older loan immediately before refinancing becomes your new level of the acquisition debt. Example: Your original loan was $300,000 but has been paid down to $250,000. You obtain a new loan in the amount of $350,000. You can only deduct interest on the $250,000, unless you use the refinance proceeds to substantially improve your home. According to IRS Publication 936, "Home Mortgage Interest Deduction," "an improvement is substantial if it adds to the value of your home, prolongs your home's useful life or adapts your home to new uses."

So, if you used $50,000 of the refinance proceeds to add a room to your house, that amount would be added to the acquisition indebtedness and you could deduct the interest you pay on $300,000 of your new loan's principal.

But now we have to look at the second category of debt. Home-equity debt involves money you borrowed but do not use to buy, build or substantially improve your home. The money can be obtained as a separate home equity loan (commonly called a HELOC), or in a cash-out refinance, as described above.

Both categories have dollar limitations. Acquisition debt cannot exceed $1 million (or $500,000 if you are married but file a separate tax return). Deductible home-equity debt cannot exceed $100,000.

Let's look at another example: Several years ago, you purchased your house for $150,000 and obtained a mortgage (or deed of trust) in the amount of $100,000. Last year, your mortgage indebtedness had been reduced to $95,000, but your house was worth $300,000.

Because rates were very low last year, you refinanced and were able to get a new mortgage of $175,000. You did not use any of the refinance proceeds to improve your house. Despite the bigger new loan, your acquisition debt is $95,000. The additional $80,000 that you took out of your equity does not qualify as acquisition debt, but because it is less than $100,000, it qualifies as a home equity loan.

Several years ago, the Internal Revenue Service ruled that one does not have to take out a separate home equity loan to qualify for this aspect of the tax deduction. However, if you would have borrowed $200,000, you would only be able to deduct interest on $195,000 of your loan -the $95,000 acquisition debt, plus the $100,000 home equity debt.

The remaining interest is treated as personal interest and is not deductible.

You should also note that for all practical purposes, there are no restrictions on the use of the money obtained from a home equity loan.

However, to deduct any mortgage interest, the loan must be secured by a deed of trust recorded among the land records in the jurisdiction where your property is recorded. If, for example, parents lend money to a child to assist in buying a home and that loan is not secured (that is, it's not recorded), the daughter cannot deduct the interest she pays to her parents.

There may be situations in which you chose not to treat the loan as secured. For example, if the loan can qualify as a business expense, you may be able to deduct more than the dollar limitations described above. According to Publication 936, "this treatment begins with the tax year for which you make the choice and continues for all later tax years. You may revoke your choice only with the consent of the Internal Revenue Service."

For years, tax lawyers have argued that the premiums that homeowners pay for private mortgage insurance - whether to the Federal Housing Administration, the Department of Veterans Affairs or to private companies - should be treated as interest that can be deducted, just like mortgage interest. A few years ago, Congress agreed, and allowed the mortgage insurance premiums to be deducted. However, the law was to expire at the end of last year.

Congress has extended this right for another year. There are, however, a number of limitations. First, your home must have been purchased between January 1, 2007, and December 31, 2010, and it must be your principal residence. Second homes do not qualify. Next, you can deduct in full the insurance premiums if your income is less than $100,000. For every $1,000 by which your income exceeds that level, you have to decrease by 10 percent the amount of the premiums that you can deduct. For married couples filing separately, this 10 percent reduction applies to every $500 over the $100,000.

Some homeowners will prepay the premium in full. Discuss the formula for deducting this amount with your tax advisors.

In recent years, homeowners older than 62 have started to consider reverse mortgages. Under this arrangement, based on the equity in your home, you can either get one lump sum payment or periodic payments from the lender. However, the interest will not become due until you move, sell your house or die. At that time, because your loan will be paid in full (and will include the accrued interest), you are eligible to claim the deduction. But beware: According to the IRS, a reverse mortgage is generally subject to the limits on home equity debt and cannot exceed $100,000.

Getting back to those million dollar loans, the IRS recently ruled that the amount over the acquisition debt is considered home equity debt. Accordingly, the IRS will now allow homeowners to deduct mortgage interest on loans up to $1,100,000.

By the end of this month, homeowners who paid more than $600 last year in mortgage interest are supposed to receive IRS Form 1098 from their lenders. That will show the total amount of interest paid in 2010. Review the amount carefully; computers can - and do-- make mistakes, and if the amount is lower than what you paid, you will not be able to deduct the full amount that you paid unless you get the error corrected.

Benny L. Kass is a Washington lawyer. This column is not legal advice and should not be acted upon without obtaining your own legal counsel. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036.

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